Chapter 15 Notes

Chapter 15 Notes - Chapter 15 Fiscal Policy Fiscal Policy...

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Unformatted text preview: Chapter 15 Fiscal Policy Fiscal Policy A. _ What Fiscal Policy Is and What It Isn’t ' Changes in federal taXes and purchases that are intended to achieve macroeconomic policy objectives, such as high employment, price stability, and high rates of economic growth are called fiscal policy. ' In the United States, the federal, state, and local governments all have responsibility for taxing and spending- a can am)ng at gov it greeting-no ore-rear ab 3. Automatic Stabilizers verses Discretionary Fiscal Policy 0 Some types of government spending and taxes that automatically increase and decrease along with the business cycle, are referred to as automaticstabilizers. r ' The word automatic means that changes in spending and taxes happen without actions by the government. ' For example, when the economy is expanding and employment. is increasing, government spending on unemployment insurance payments to workers who have lost their jobs will automatically decrease. Retreat on a more unnerved-ed a [(33 Wags WWWCWWWM “gimme ( and u ice terror) . C. An Gverview of Government Spending and Taxes ' The size of the federal government expanded significantly during the'Great Depression. ' As a fraction of GDP, the federal government’s purchases of goods and services have been _ declining since the Korean War in the early 19503. 0 Total expenditures by the federal government including transfer payments rose slowly from 1950 through the early 19903 and fell from 1992 to 2001, before rising again. r mm @6ch Cam mflwpf AD E H ‘ 7W0 Mugs: m WWW Of mmgflfl 60W pure/mes- I y: I "L1 @7me _ . ’V 6i 92 fr AD Federal government expenditures include purchases plus all other federal government spending (e.g., transfer payments, defense spending, grants to state and local governments, interest payments, and other expenditures). The Effects of Fiscal Policy on Real GDP and the Price Level A. D a? mean Expansionary and Contractionary Fiscal Policy: An initial Look Decreasing government purchases or raising taxes can slow the growth of aggregate demand and reduce the inflation rate. _ Expansionaiy fiscal policy involves increasing government purchases or decreasing taxes. To Mower rat-tie ' An increase in government purchases will increase aggregate demand. If the individual income tax is cut, household disposable income and consumption spending will rise. Tax cuts on business income can increase aggregate demand by increasing business investment. The goal of both expansionary monetary policy and expansionary fiscal policy is to increase aggregate demand relative to what it would have been without the policy. Contractionary fiscal policy involves decreasing government purchases or increasing taxes. Policymakers use contractionary fiscal policy to reduce increases in aggregate demand that seem likely to lead to inflation. _ _ _ Decreasing government purchases or increasing taxes can keep real GDP from moving beyond its potential level. Using Fiscal Policy to Influence Aggregate Bemand: A More Complete Account Fiscal policy affects aggregate demand. _ . Increasing government purchases or cutting taxes can shift aggregate demand to the right. Contractionary fiscal policy can keep real GDP from moving beyond its potential level. A Summary of How Fiscal Policy Affects Aggregate Demand When there is recession, an expansionary fiscal policy will result in'a higher real GDP and higher price level. S s ® few-:5 Mb b—R‘b ' w ‘ h . £1 %@\\/ :27 \(j (1 g I \ Q65) 80W com vifldfiazg } ' c3902. aim I I {X :7 Receggxm //i\ at PMSKONW whcg ' A contractionary fiscal policy causes the price level to rise by less than it would have without the policy. ' Extra Solved Problem 15-2 Fiscal Policy and Aggregate Demand The graph on the next page illustrates an economy that is in long-run equilibrium in Year 1 at a potential real GDP of $13.5 trillion and a price level of 120. In Year 2, growth in technology and increases in capital and labor increase potential real GDP to $14.0 trillion and the long-run aggregate supply curve shifts from LRAS1 to LRASZ. Assume that aggregate demand in Year 2 increases to AD; and that there is no change in monetary policy that would increase aggregate demand further. For simplicity, assume that the short—run aggregate supply curve (SRAS) does not shift. In Year 2, the intersection of the short-run aggregate demand curve and aggregate supply curves occurs at a price level of 122 and a real GDP of $13 .8‘ trillion. a. How can fiscal policy be used to allow the economy-to reach equilibrium at its new potential real GDP? 13. Draw a graph that illustrates the impact of this fiscal policy. Qeceseibn :7 {WCM pawl I I q‘\st\t\ int/(6(1st C1 cl l \00 :23 Cotosée \[ lb 4‘ \M loo 0t “meow/t t W) 2—7 people/tr, e9 MMXCIOOUOVMSUW . _ - i _ match-er: l-‘MDC TOW A mu 1" I I - \l l) cam “KP—oi)? as $600 (MC/l Am (:2 \s _' "il‘alooywmlw WW _" toxin t‘m\t new» a moses m 2vame mac \SQTSGL smallet mm (7) loemoga auto non/1003 ' “t \S W "www— i mm mm oolkl ta. m We . F‘rice iavel (GE)? price defiatcr, 2909 = we) LeasE Lansz acme1 = 853482 122 _ $4.0 a $13.5 Beat GDP (tritlions of 2900 dollars) SOLVENG THE PROBLEM: I Step 1 : Step 2: Step 3: Review the chapter material. _ r This problem is about the use of fiscal policy, so you may want to read the section “The Effects of Fiscal Policy on Real GDP and the Price Level” which begins on page 934 in the textbook. Answer question (a) by explaining how fiscal policy can be used to allow the economy to reachjequilibrium at the new Ievei of potential real GDP. _ Government spending is a direct increase in aggregate demand, while changes in taxes affect spending indirectly through changes in income. Therefore, the tax reduction would have to be greater than a government spending increase to achieve the same increase in aggregate demand. Answer question (b) by drawing a graph that illustrates the impact of this fiscal policy. ' ' The graph on the next page shows the impact of a change in spending or taxes that shifts aggregate demand from AD; (aggregate demand in Year 2 without a change in fiscal policy) to AD3 (aggregate demand in Year 2 with a change in fiscal policy). Note the price level is greater (125) as a result of the fiscal policy than it would have been without it (122). Price level L351 L882 gees price deflator, ' aces -_- me) i ............................................... I I 122 .................................... .u ,_ ..... .. I 120 ................................................ '33; I o $13.5 $14.0 Real GDP (triiions of 2059 deems) the Government Purchases and Tax Economists refer to the series of induced increases in consumptiOn spending that results from an initial increase in autonomous expenditures as the multiplier effect. The ratio of the change in equilibrium real GDP to the initial change in government purchases is known as the government purchases multiplier: ' Change in equilibrium real GDP Government purchases multiplier = ' . Change 111 government purchases ' Economists have estimated that the government purchases multiplier has a value of about 2. Cutting taxes increases the disposable income of households and consumption spending and also produces a multiplier effect. The tax multiplier is a negative number because changes in taxes and changes in real GDP move in opposite directions: An increase in taxes reduces disposable income, consumption, and real GDP. ' ' A decrease in taxes raises disposable income, consumption, and real GDP. The expression for the tax multiplier is: Change in equilibrium real GDP Tax multiplier = . Change in taxes A. Fiscal Policy in Action: The'Tax Rebate of 2668 ' In early 2008, economists advising President Bush believed that the housing crisis, the resulting credit crunch and rising oil prices had increased the risk of recession. ' Congress and the president cut taxes through rebates of taxes already paid. ° The rebates were sent as checks during the summer of 2008. ' Though the effect of the rebates is uncertain at similar rebate was used to combat the recession of 2001. _ ' One-time rebates, such as those in 2001 and 2008, increase consumers’ current income but not their permanent income. ' Therefore, a tax rebate is likely to increase consumption spending less than would a permanent .. WW imp @ngomgitim decisions om . 4:000,ng gamma 0W €2me gaming: (rm/nor row ' ' B. The Effect of Changes in Tax Rates O e .w ) ° A cut in tax rates affects equilibrium real GDP through two channels: 1. A cut in tax rates increases the disposable income of houSeholds, which leads them to increase their consumption spending. - 2. A cut in tax rates increases the size of the multiplier effect. “genome mmqr‘eaier me: Of i Name a an actomm cos firmware i a CO more «3/» tmcwetaer' " W m5 (2. Taking into account the Effects of Aggregate Supply ° The actual change in real GDP resulting from an increase in government purchases or a cut in taxes will be less than indicated by the simple multiplier effect with a constant price level. D. The Multipliers Work in Both Directions ‘ ' The multipliers can work in two ways: I. Increases in government purchases and cuts in taxes have a positive multiplier effect on equilibrium real GDP. _ _ 2. Decreases in government purchases and increases in taxes also have a multiplier effect on equilibrium real GDP, only in this case the effect is negative. The Limits of Using Fiscal Policy to Stabilize the Economy Recon Wren Owner on M econ rs in . :, ' one lag ‘ Getting the timing right can be more difficult with fiscal policy than with monetary policy for 0 main reasons: 1. Control over monetary policy is concentrated in the hands of the Federal Open Market Committee, which can change monetary policy at any of its meetings. 2. The president and a majority of the 535 members of Congress have to agree on changes in fiscal policy. A. Does Government Spending Reduce i3rivate Spending? . _ D) '_"’ “ 4\ g] :5 RD gwg Kb ABEL a mmyg eh‘fi W3 -~ vmeg-éy “V p: WW 1% 6m :5 Tm): “MD ' The size of the multiplier from government spending to increase aggregate demand may be limited if the increase in government purchases causes private components of aggregate expenditures — consumption, investment, or net exports — to fall. - A decline in rivate ex enditures as a result of an increase in government urchases is called P P a P crowding out. 8. Crowding Gut in the Short Run - The greater the sensitivity of consumption, investment, and net exports to changes in interest rates, the more crowding out will occur. _ ' ° In a deep recession, many firms maybe so pessimistic about the future and have so much excess ' capacity that investment spending falls to very low levels and is unlikely to fall much further, even if interest rates rise. - In this case, crowding out isunlikely to be a problem. “* WM \U‘t‘gren ’t in (a must come at no ewperfire 0‘: Qtwcfie expewtdores _ . “iii? (DOOM, Expandn‘ronfl; ié 3%‘9/0 Oi— G©P and $3 To 570/0 'We \NW e2 0L {teams in tit-metre amendimfi‘ at Ms C. Crowding Gut in the Long Run ' Most economists agree that the long—run effect of a permanent- increase in government spending is complete crowding out. ‘ In the long run, the decline in investment, consmnption,_and net exports exactly offsets the increase in government purchases, and aggregate demand remains unchanged. Deficits, Surpluses, and Federal Government Bent - The federal government’s budget shows the relationship between its expenditures and its tax revenue. ' A budget deficit is the situation in which the government’s expenditures are greater than its tax revenue. ' - NW \5- m mowwev Svm T1105? mg 67 ex; WMGKMQS my mom 7? - “ CK me "m CUWCW Qf€€d s “\M‘M 'Wwova cmmg‘es m 610? cm mm \4 AW . ' w] 8mm mkficd 6W Lfiaé' SQR-g _ W- WW . ? 350$}in \R 01.1% ; N‘\L' m. to hm -QY€@¥@‘TNL F” ; Max 66 ‘ mowdmg 00% 3%” Q—WQKJNQ 9 how (was panama C, '1} am W W ' h mama "x n V“ A budget surplus it the situation in which the government’s expenditures are less than its tax revenue. How the Federal Budget Can Serve as an Automatic Stabilizer Most of the increase in the federal budget deficit during recessions takes place without Congress and the president taking any action because of the effects of automatic stabilizers. Deficits occur automatically during recessions for two reasons: 1. During a recession, wages, profits, and government tax revenues fall. 2. The government automatically increases its spending on transfer payments when the economy moves into recession. The cyclically adjusted budget deficit or surplus is the deficit or surplus in the federal government’s budget if the economy were at potential GDP. Economists often look at the cyclically adjusted budget deficit or surplus because budget deficits automatically increase during recessions and decrease during expansions. This can provide a more accurate measure of the effects on the economy of the government’s spending and tax policies than the actual budget deficit or surplus. is decrees} 0h 1? ESch , heeled it h £fil€l§k¥l§xob 4% some QOWW‘g ’9‘? _ Should the Federal Budget Always Be Balanced? Although many economists believe that it is a good idea for the federal govornment to have a balanced budget when the economy is at potential GDP, few believe that the federal government shouldtryto balance its budget every year. 7 ‘ poring ' an: recession "mks imph-es ~€.\"Wi‘ increasinq taxes or dr CI 100er ML which WAN, M) are Niagara Th2 recession - The Federal Government Debt When the federal government runs a budget deficit, the Treasury must borrow fimds from investors by selling Treasury securities (e.g., bonds). The total value of U.S. Treasury bonds outstanding is referred to as the federal government debt or, sometimes, as the national debt. By the end of May 2008, the federal government debt was $9.4 trillion, but more than half of this debtwas held by federal government agencies. _ The impact of the baby boom on the Social Security and Medicare systems has led the Social Security and Medicare trusrfimd to acquire more than $4.1 trillion worth of Treasury debt. When baby boomers retire, the trust fund will sell those bonds to make payments to retirees. ' Dr [5 Government Debt 3 Probiem? ' Debt can be a problem for a government for the same reasons that debt can be a problem for a household or a business. ° In the long run, a debt that increases in size relative to GDP can pose a problem because the government may have to raise taxes to high levels or out back on other spending to make interest payments on the debt. The Effects ofFiscaI Policy in the Long Run - Some fiscal policy actions are intended to have long~run effects by expanding the productive capacity of the economy and increasing the rate of economic growth. ' These policy actions primarily affect aggregate supply rather than aggregate demand and, therefore, are referred to as supply-side economics. ‘31 ifMCQS ea wag-es seems my; Waggg WNW-tr WWW Wore wet” mtg A. The Long-Run Effects cf Tax i’oiicy ' The difference between the pre—tax and post—tax-return to an economic activity is known as the tax wedge. ° The tax wedge applies to the marginal tax rate, which is the fraction of each additional dollar of income that must be paid in taxes. 4‘ '\ meet more ' The following are effects on aggregate supply from cutting taxes: 1, Reducing marginal tax rates on individual income will reduce the tax wedge faced by workers, thereby increasing the quantity of labor supplied. ' ' ' 2. Cutting the marginal corporate income tax rate will encourage investment spending by increasing the return corporations receive from new investments in equipment, factories, and 'office buildings. _ 3. Lowering tax rates on dividends and capital gains increases the supply of loanable funds from households to firms, increasing saving and investment and lowering the equilibrium real interest rate i SUWM Lemme eager i :9 t muesmm _ *me gmgg Swofwsflmm =25 $901m’.- MW? 8’ WUHCUS momffi, \UQ \N‘xci 912ij WOVWS @{rz'iméed WW :3 www A3? um {mpx'xes mm wmmg Vac/61023 figWg‘W 5014 "m5 ‘5 00* Tb film, W99 W52 firm ' cam mqwmg “fiflw TD \Le-Qp NDH’ZQRS CM 'm 30W) WW "WWW/t- Cam mm mm H wovmsg «Ci-9% "(OOQNUJ I'Wxs; £4wa 89; we 0.3 8 Wm my 3- muffle row; 00%.. pcw- \\ LUDWUS $7M? :fifi’h‘m WWW \\ \Wflrg \pmcmwg \10 W‘I‘Mfig 0ng mg C(mgéd m 0mm u; m‘se Tax Simplification If the tax code were greatly simplified, the economic resources currently used by the tax preparation industry would be available to produce other goods and services. A simplified tax code would increase economic efficiency by reducing the number of decisions made by households and firms solely to reduce their tax payments. The Economic Effect of Tax Reform If tax reduction and simplification are effective, the economy wili experience increases in labor supply, saving, investment, and the formation of new firms. Economic efficiency will also be improved. Together, these factors will result in an increase in the quantity of real GDP supplied at every price IeVel. ' ' A successful policy of tax reductions and simplifications will benefit the economy by increasing output and employment and, at the same time, may result in smaller increases in the price level. How Large Are Supply-«Side Effects? - Most economists agree that there are supply-side effects to reducing taxes: decreasing marginal income tax rates will increase the quantity of labor supplied, cutting the corporate income tax will increase investment spending, and so on. The magnitude of the effects is subject to considerable debate. The size of the supply—side effects of tax policy can be resolved only by careful studies of the effects of differences in tax rates on labor supply and saving and investment decisions. © mmw : ‘W '\00r%1\: awaken?) {OD fitl:;\,u 3‘— deci‘rficw A . @ W: \N\ mm (mi N W: Mgfi :\ W3” \WO h 1/} 9x - _ \qg « \HO : 30/0 M 2 WWW D— , MU : 73W ‘3' 6 fl) ...
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Chapter 15 Notes - Chapter 15 Fiscal Policy Fiscal Policy...

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